Identiv 10Q 2002 Q1 Quarterly report

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q


þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended March 31, 2002

or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the transition period from to

Commission File Number: 0-22689

SCM Microsystems, Inc.

(Exact name of registrant as specified in its charter)


Delaware		77-0444317
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

47211 Bayside Parkway, Fremont, CA 94538

(Address of principal executive offices including zip code)

(510) 360- 2300

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. þ Yes o No

At May 1, 2002, 15,602,842 shares of common stock were outstanding.

TABLE OF CONTENTS


	Item 1. Financial Statements
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosure about Market Risk Foreign Currencies
PART II: OTHER INFORMATION
	Item 1. Legal Proceedings
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES

Item 1. Financial Statements

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS



			Three Months
			Ended
			March 31,

			2002			2001


			(In thousands, except
			per share data)
			(Unaudited)
Net revenue			$	43,429		$	45,107
Cost of revenue				28,849			40,863

		Gross profit		14,580			4,244

Operating expenses:
	Research and development			2,851			3,582
	Selling and marketing			6,427			8,576
	General and administrative			4,147			6,193
	Amortization of goodwill and intangibles			289			3,708
	Separation costs and restructuring charges			789			—
	In-process research and development			—			115

		Total operating expenses		14,503			22,174

		Income (loss) from operations		77			(17,930	)
Loss from investments				—			(5,679	)
Interest and other, net				(172	)		(33	)

		Loss before income taxes and minority interest		(95	)		(23,642	)
Benefit for income taxes				208			5,188
Minority interest in loss of consolidated subsidiary				—			100

		Net income (loss)	$	113		$	(18,354	)


	Basic net income (loss) per share		$	0.01		$	(1.20	)

	Diluted net income (loss) per share		$	0.01		$	(1.20	)

	Shares used to compute basic net income (loss) per share			15,542			15,269

	Shares used to compute diluted net income (loss) per share			16,211			15,269


Comprehensive income (loss):
	Net income (loss)		$	113		$	(18,354	)
	Unrealized gain on investments, net of deferred taxes			24			1,049
	Foreign currency translation adjustment			203			(2,442	)

		Total comprehensive income (loss)	$	340		$	(19,747	)

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS


			March 31,			December 31,
			2002			2001


			(In thousands)
			(Unaudited)
ASSETS
Current assets:
	Cash, cash equivalents and short-term investments		$	59,568		$	59,421
	Accounts receivable, net			39,892			44,368
	Inventories			37,237			32,690
	Other current assets			8,500			8,174

		Total current assets		145,197			144,653
Property and equipment, net				10,002			10,464
Investments				1,522			1,482
Long-term deferred income taxes				11,221			11,252
Intangible assets, net				4,478			4,765
Goodwill, net				12,566			12,566
Other assets				92			406

		Total assets	$	185,078		$	185,588

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities:
	Accounts payable		$	27,231		$	28,252
	Accrued compensation and related benefits			2,708			2,755
	Accrued restructuring and professional fees			3,228			4,286
	Accrued royalties			2,292			1,988
	Other accrued expenses			5,096			3,992
	Income taxes payable			1,766			2,010

		Total current liabilities		42,321			43,283
Deferred tax liability				434			434
Minority interest				90			90
Stockholders’ equity:
	Capital stock			16			16
	Additional paid-in capital			224,457			224,433
	Deferred stock compensation			(761	)		(849	)
	Accumulated deficit			(74,295	)		(74,408	)
	Other cumulative comprehensive loss			(7,184	)		(7,411	)

		Total stockholders’ equity		142,233			141,781

		Total liabilities and stockholders’ equity	$	185,078		$	185,588

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



					Three Months
					Ended
					March 31,

					2002			2001


					(In thousands)
					(Unaudited)
Cash flows from operating activities:
	Net income (loss)				$	113		$	(18,354	)
	Adjustments to reconcile net income (loss) to net cash used in operating activities:
		Deferred income taxes				31			(5,200	)
		Depreciation and amortization				1,059			4,453
		In-process research and development				—			115
		Minority interest in earnings of subsidiary				—			(100	)
		Amortization of deferred stock compensation				88			192
		Loss on long-term investments				—			5,679
		Changes in operating assets and liabilities:
			Accounts receivable			4,044			4,100
			Inventories			(4,582	)		826
			Other assets			(36	)		(1,967	)
			Accounts payable			(983	)		3,191
			Accrued expenses			403			(3,769	)
			Income taxes payable			(257	)		(257	)

				Net cash used in operating activities		(120	)		(11,091	)

Cash flows used in investing activities:
	Capital expenditures					(438	)		(2,109	)
	Proceeds from disposal of fixed assets					13			—
	Business acquired, net of cash received					—			(2,366	)
	Maturities of short-term investments					—			26,580
	Purchases of short-term investments					(2,597	)		(25,460	)

				Net cash used in investing activities		(3,022	)		(3,355	)

Cash flows from financing activities:
	Proceeds from issuance of equity securities, net					26			153

				Net cash provided by financing activities		26			153
Effect of exchange rates on cash and cash equivalents						666			204

Net decrease in cash and cash equivalents						(2,450	)		(14,089	)
Cash and cash equivalents at beginning of period						59,421			33,699

Cash and cash equivalents at end of period					$	56,971		$	19,610

Supplemental disclosures of cash flow information:
	Cash paid for income taxes				$	208		$	389

	Cash paid for interest				$	7		$	—

See notes to condensed consolidated financial statements.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2002

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulations S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three-month period ended March 31, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. For further information, refer to the financial statements and footnotes thereto included in SCM Microsystems’ (“SCM”) December 31, 2001 Annual Report on Form 10-K.

Reclassifications — Certain reclassifications have been made to the 2001 financial statement presentation to conform to the 2002 presentation.

2. Long-Term Investments

Long-term investments consist of the following (in thousands):


		March 31,		December 31,
		2002		2001

Investment in ActivCard, at fair value		$	915	$	1,094
Investment in SmartDisk, at fair value			607		388

	Total	$	1,522	$	1,482

During each quarter, the Company evaluates its investments for possible asset impairment by examining a number of factors including the current economic conditions and markets for each investment, as well as, their cash position and anticipated cash needs for the short- and long-term. During the first and fourth quarters of 2001, because of the persistent deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties by these companies in obtaining additional funding, SCM determined that our investments in SmartDisk, Spyrus and Satup were permanently impaired. Accordingly, in the first quarter of 2001 we wrote down our investment in SmartDisk to its fair market value as of March 31, 2001 and wrote down our investment in Spyrus to its estimated value which approximated 20% of the original cost. The result was a charge to the income statement of $5.7 million in the first quarter of 2001. In the fourth quarter of 2001, we wrote off our remaining balances for Spyrus, Satup Databroadcasting AG and our investment in a Singapore subsidiary of PC Card. The result was a charge to the income statement of $2.8 million in the fourth quarter of 2001. As of March 31, 2002, SCM’s ownership of all outstanding shares of Spyrus was approximately 13.4%. SCM’s ownership in Satup as of March 31, 2002, was approximately 10%. Satup is also a customer of SCM.

3. Inventories

Inventories consist of (in thousands):


	As of		As of
	March 31,		December 31,
	2002		2001

Raw materials	$	22,997	$	20,498
Finished goods		14,240		12,192

	$	37,237	$	32,690

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

4. Goodwill and Other Intangible Assets

SCM adopted Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”),Goodwill and Other Intangible Assets, as of January 1, 2002. As defined by SFAS No. 142, the Company identified two reporting units which constitute components of SCM’s business that included goodwill. As of January 1, 2002, the fair value of these two reporting units were assessed and compared to the respective carrying amounts. Upon completion of the transitional impairment test, the fair value for each of the Company’s reporting units approximated or exceeded the reporting unit’s carrying amount and no impairment was indicated.

Intangible assets and goodwill consist of the following (in thousands):



			March 31, 2002							December 31, 2001

			Gross							Gross
	Amortization		Carrying		Accumulated					Carrying		Accumulated
	Period		Amount		Amortization			Net		Amount		Amortization			Net

Core Technology		60 months	$	5,290	$	(3,034	)	$	2,256	$	5,290	$	(2,769	)	$	2,521
Trade name		Indefinite		3,903		(1,703	)		2,200		3,903		(1,703	)		2,200
Non-compete		24 months		719		(697	)		22		719		(675	)		44

Total Intangibles				9,912		(5,434	)		4,478		9,912		(5,147	)		4,765
Goodwill and other intangibles				29,924		(17,358	)		12,566		29,924		(17,358	)		12,566

Total			$	39,836	$	(22,792	)	$	17,044	$	39,836	$	(22,505	)	$	17,331

In accordance with SFAS No. 142, only SCM’s intangible assets relating to core technology and non-compete agreements are subject to amortization. Assembled workforce and customer relations were recorded as goodwill as of January 1, 2002.

Amortization of goodwill and intangibles in the first quarter of 2002 was $0.3 million compared with $3.7 million for the same period of 2001.

Estimated future amortization expense is as follows (in thousands):


Fiscal Year	Amount

2002 (remaining 9 months)	$	776
2003		730
2004		478
2005		285
2005		9

Total	$	2,278

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Had the provisions of SFAS No. 142 been applied for the first quarter ended March 31, 2002 and 2001, the Company’s net income (loss) and net income (loss) per share would have been as follows (in thousands, except per share amounts):



		Three Months Ended

		March 31,		March 31,
		2002		2001

Net income (loss), as reported		$	113	$	(18,354	)
Add back amortization:
	Assembled workforce		—		129
	Customer relations		—		117
	Trade name		—		309
	Goodwill		—		2,583
	Related income tax effect		—		(91	)

Adjusted net income (loss)		$	113	$	(15,307	)


Net income (loss) per share:
Basic net income (loss) per share, as reported		$	0.01	$	(1.20	)
Add back above amortization and related income tax effect			—		0.20

Adjusted basic net income (loss) per share		$	0.01	$	(1.00	)


Diluted net income (loss) per share, as reported		$	0.01	$	(1.20	)
Add back above amortization and related income tax effect			—		0.20

Adjusted diluted net income (loss) per share		$	0.01	$	(1.00	)

5. Separation and Restructuring Charges

During 2001, SCM incurred one-time charges of approximately $5.2 million primarily relating to legal settlement costs and expenses resulting from the consolidation of operations in various facilities. In the first quarter of 2002, SCM incurred separation and one-time charges of approximately $0.8 million, primarily due to costs incurred in preparation of the anticipated separation of its Digital Media and Video division and employee severance costs. The following summarizes the expenses related to these activities during 2001 and the first quarter of 2002 (in thousands):


	Legal			Lease			Asset			Severance and
	Settlements			Commitments			Write Downs			Other Costs			Total

Provision for 2001	$	1,830		$	1,675		$	336		$	1,423		$	5,264
Changes in estimates		—			(15	)		(53	)		(2	)		(70	)

		1,830			1,660			283			1,421			5,194
Payments or write offs in 2001		(1,252	)		(145	)		(240	)		(841	)		(2,478	)

Balance as of December 31, 2001		578			1,515			43			580			2,716
Provision for Q1 2002		—			—			20			769			789
Payments or write offs in Q1 2002		(355	)		(171	)		(21	)		(1,251	)		(1,798	)

Balances as of March 31, 2002	$	223		$	1,344		$	42		$	98		$	1,707

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The severance and other costs for the year ended December 31, 2001 primarily related to the reduction in force of approximately 81 employees. Approximately 20 of these employees were from Operations, 40 were from Sales and Marketing, 13 were from Research and Development and 8 were from General and Administrative functions. Approximately 44 were in the U.S., 19 in Asia and 18 were in Europe.

The severance and other costs for the quarter ended March 31, 2002 primarily related to legal and consulting costs of $0.4 million for the anticipated separation of our Digital Media and Video division, $0.3 million for severance and related costs and $0.1 million for an asset impairment. The severance costs related to the termination of nine employees, eight in the United States and one in Europe. Approximately four employees were from Sales and Marketing, two from Operations, two from General and Administrative functions and one from Research and Development.

6. Recent Accounting Pronouncement

In August 2001, the Financial Accounting Standard Board issued SFAS No. 144.“Accounting for the Impairment of Long Lived Assets.” SFAS No. 144 supercedes SFAS No. 121, “Accounting for the Impairment of Long Lived Assets to be Disposed Of,” addressing financial accounting and reporting for the impairment or disposal of long lived assets. The Company early adopted SFAS No. 144 in the fourth quarter of 2001. The adoption of SFAS No. 144 did not have a material effect on the Company’s financial position, results of operations or cash flows.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141,“Business Combinations,” and SFAS No. 142,“Goodwill and Other Intangible Assets.” SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will rather be tested at least annually for impairment. Under the provisions of SFAS No. 142, any impairment loss identified upon adoption of this standard is recognized as a cumulative effect of a change in accounting principle, which is charged directly to retained earnings. Any impairment loss incurred subsequent to initial adoption of SFAS No. 142 is recorded as a charge to current period earnings. SCM adopted SFAS No. 142 on January 1, 2002 and stopped amortizing goodwill and certain other intangibles that resulted from business combinations completed prior to June 30, 2001. Amortization of intangibles in fiscal 2002 for acquisitions made before June 30, 2001 is expected to be approximately $1.1 million (See Note 4).

7. Acquisitions


	*Dazzle Multimedia, Inc.*

In the first quarter of 2001, SCM acquired an additional 2.8% of the outstanding share capital of Dazzle Multimedia, Inc. (Dazzle), a consolidated subsidiary, for approximately $2.4 million. The $2.4 million increased intangible assets by $2.3 million, and $0.1 million was expensed in the first quarter of 2001 for Dazzle’s research and development efforts that had not reached technological feasibility and had no future uses.


	*Towitoko AG*

In March 2002, SCM announced its intent to acquire Towitoko AG, a leading supplier of smart card-based security solutions for home banking and private PC access in the German-speaking market. Towitoko AG is a private company based in Munich. The acquisition will be recorded under purchase accounting and is expected to be completed in the second quarter of 2002. The purchase price is expected to be approximately $5 million in cash.

SCM MICROSYSTEMS, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

8. Segment Reporting, Geographic Information and Major Customers

SCM adopted the provisions of Statement of Financial Accounting Standards No. 131 (“SFAS No. 131”), “Disclosures about Segments of an Enterprise and Related Information,” in 1998. SFAS No. 131 establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The method for determining what information to report is based on the way that management organizes the operating segments within SCM for making operating decisions and assessing financial performance. Our chief operating decision maker is considered to be our executive staff, consisting of the Chief Executive Officer and Chief Financial Officer.

Prior to January 1, 2002, management had aligned our organization along three business segments: Digital TV and Video, Digital Media and PC Security. Beginning in 2002 and going forward, we have structured our operations around two businesses: Security, which comprises our digital TV and PC security products, and Digital Media and Video, which comprises our digital media and digital video products. The executive staff reviewed financial information and business performance along these two product segments in the first quarter of 2002. We evaluate the performance of our business segments at the revenue and gross margin level. Our reporting systems do not track or allocate operating expenses or assets by segment. We do not include intercompany transfers between segments for management purposes. Segment information for the first quarter of 2001 has been restated to reflect the new business segments.

Summary information by segment for the quarters ended March 31, 2002 and 2001, is as follows (in thousands):



		Quarter Ended
		March 31,

		2002		2001

Digital Media and Video:
	Revenues	$	21,049	$	26,371
	Gross profit		5,477		3,511
Security:
	Revenues	$	22,380	$	18,736
	Gross profit		9,103		733
Total:
	Revenues	$	43,429	$	45,107
	Gross profit		14,580		4,244

Geographic revenues are based on the country where the customers are located. Information regarding revenues by geographic region for the three months ended March 31, 2002 and 2001 are as follows (in thousands):



	Quarter Ended
	March 31,

	2002		2001

United States	$	19,158	$	19,043
Europe		16,494		16,471
Asia-Pacific		7,777		9,593

	$	43,429	$	45,107

One customer represented 16% of SCM’s total net revenue for the quarter ended March 31, 2002. One customer represented 12% of SCM’s total net revenue for the quarter ended March 31, 2001.


Item 2.	*Management’s Discussion and Analysis of Financial Condition and Results of Operations*

This Quarterly Report on Form 10-Q contains forward-looking statements that are subject to a number of risks and uncertainties, many of which are beyond our control. All statements, other than statements of historical facts included in this Quarterly Report on Form 10-Q regarding our strategy, future operations, financial position, estimated revenues or losses, projected costs, prospects, plans and objectives of management are forward-looking statements. When used in this Quarterly Report on Form 10-Q, the words “will,” “believe,” “anticipate,” “estimate,” “expect” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. All forward-looking statements speak only as of the date of this Quarterly Report on Form 10-Q. You should not place undue reliance on these forward-looking statements. Although we believe that our plans, intentions and expectations reflected in or suggested by the forward-looking statements that we make in this Quarterly Report on Form 10-Q are reasonable, we can give no assurance these plans, intentions or expectations will be achieved. We disclose important factors that could cause our actual results to differ materially from our expectations under “Factors That May Affect Future Operating Results.” These cautionary statements qualify all forward-looking statements attributable to us or persons acting on our behalf.

The following information should be read in conjunction with the unaudited condensed consolidated financial statements and notes thereto set forth in Item 1 of this quarterly report. We also urge readers to review and consider our disclosures describing various factors that could effect our business, including the disclosures under Management’s Discussion and Analysis of Financial Condition and Results of Operations and Risk Factors and the audited financial statements and notes thereto contained in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on March 26, 2002.

Overview

SCM Microsystems designs, develops and sells hardware, software and silicon that enables people to conveniently and securely access digital content and services, including content and services that have been protected through digital encryption. We sell our products primarily into two broad markets: Security and Digital Media. Our target customers vary by market. For the Security market, our target customers are primarily manufacturers in the consumer electronics, computer and conditional access system industries. For the Digital Media market, our target customers are end user consumers as well as manufacturers in the computer and consumer electronics industries. We sell and license our products through a direct sales and marketing organization, both to the retail channel and to original equipment manufacturers, or OEMs. We also sell through distributors, value added resellers and systems integrators worldwide. Operationally, through 2001 we organized our business around three divisions: Digital TV and Video, PC Security and Digital Media. Going forward and beginning in fiscal 2002, we have structured our operations around two businesses: Security and Digital Media and Video. On February 28, 2002, we announced our intention to separate our Digital Media and Video business as an independent entity and make our Security business the core focus of our strategy going forward. We expect that the various activities relating to the separation of the Digital Media and Video business will not be completed for several months from the date hereof. We are evaluating various strategies to separate the Digital Media and Video business, including a spin-off or sale. We were organized in Delaware in 1996.

Critical Accounting Policies and Estimates

Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses SCM’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to product returns, customer incentives, allowance for doubtful accounts, inventories, asset impairment, realization of deferred tax assets, accrued warranty reserves, restructuring costs, and contingencies and litigation. Management bases its estimates and judgements on historical experience and on various other factors that are

believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Management believes the following critical accounting policies, among others, affect our more significant judgements and estimates used in the preparation of our consolidated financial statements.


	•	SCM recognizes product revenue upon shipment, net of estimated returns, provided that collection is determined to be probable and no significant obligations remain. Product return from distributors is subject to agreements allowing limited rights of return, rebates, and price protection. Accordingly, we reduce revenue recognized for estimated future returns, price protection when given, and rebates at the time the related revenue is recorded. The estimates for returns are adjusted periodically based upon historical rates of returns, inventory levels in the distribution channel, and other related factors. The estimates and reserves for rebates and price protection are based on historical rates. While management believes we can make reliable estimates for these matters, nevertheless unsold products in these distribution channels are exposed to rapid changes in consumer preferences or technological obsolescence, product updates or competing products. Accordingly, it is possible that these estimates will change in the near future or that the actual amounts could vary materially from our estimates and that the amounts of such changes could seriously harm our business.

	•	SCM maintains allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of SCM’s customers were to deteriorate, resulting in an impairment of their ability to make payments, SCM may make additional allowances as necessary.

	•	SCM writes down inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

	•	SCM holds minority interests in companies having operations or technologies in areas within or adjacent to our strategic focus, some of which are in publicly traded companies and some of which are in non-publicly traded companies whose value is difficult to determine. SCM records an investment impairment when we believe an investment has experienced a decline in value that is other than temporary. Future adverse changes in market conditions or poor operating results of underlying investments could result in losses or an inability to recover the carrying value of the investment that may not be reflected in an investment’s current carrying value, thereby possibly requiring an impairment charge in the future.

	•	In assessing the recoverability of the Company’s goodwill and other intangibles, SCM must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets not previously recorded. On January 1, 2002, SCM adopted SFAS No. 142,“Goodwill and Other Intangibles Assets,” and is required to analyze its goodwill and intangible assets for impairment issues on a periodic basis. As a result of the intended separation of our Digital Media and Video business, in the fourth quarter of 2001, we recorded an asset impairment of approximately $36.1 million based on our findings that the intangible assets from past acquisitions were impaired.

	•	The carrying value of the Company’s net deferred tax assets assumes that SCM will be able to generate sufficient future taxable income in certain tax jurisdictions. If these estimates and related assumptions change in the future, we may be required to record additional valuation allowances against our deferred tax assets resulting in additional tax expense in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets quarterly and assesses the need for additional valuation allowances quarterly.


	•	SCM accrues the estimated cost of product warranties at the time revenues are recognized. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by actual warranty costs including, material usage or service delivery costs incurred in correcting a product failure. If actual material usage or service delivery costs differ from our estimates, revisions to our estimated warranty liability would be required.

Recent Accounting Pronouncements

In August 2001, the Financial Accounting Standard Board issued SFAS No. 144,“Accounting for the Impairment of Long Lived Assets.” SFAS No. 144 supercedes SFAS No. 121,“Accounting for the Impairment of Long Lived Assets to be Disposed Of,” addressing financial accounting and reporting for the impairment or disposal of long lived assets. This statement is effective for our fiscal year beginning January 1, 2002. The Company early adopted SFAS No. 144 in the fourth quarter of 2001.

In June 2001, the Financial Accounting Standards Board issued SFAS No. 141,“Business Combinations,” and SFAS No. 142,“Goodwill and Other Intangible Assets.” SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting of goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will rather be tested at least annually for impairment. Under the provisions of SFAS No. 142, any impairment loss identified upon adoption of this standard is recognized as a cumulative effect of a change in accounting principle, which is charged directly to retained earnings. Any impairment loss incurred subsequent to initial adoption of SFAS No. 142 is recorded as a charge to current period earnings. As of January 1, 2002, SCM has adopted SFAS No. 142 and, as a consequence stopped amortizing goodwill that resulted from business combinations completed prior to June 30, 2001. Amortization of intangibles for fiscal 2002 for acquisitions made before June 30, 2001 is expected to be approximately $1.1 million. Intangible assets of approximately $2.1 million were reclassed to goodwill and amortization ceased effective January 1, 2002. We do not expect to take any charges associated with the adoption of SFAS No. 142.

Acquisitions


	Dazzle Multimedia, Inc.


	Towitoko AG

Results of Operations

Net Revenue.Revenue from product sales is recognized upon product shipment, when a purchase order has been received, the sales price is fixed and determinable and collection of the resulting receivable is

probable. Provisions for estimated warranty repairs and returns and allowances are provided for at the time products are shipped. Net revenue for the quarter ended March 31, 2002 was $43.4 million compared to $45.1 million in 2001, a decrease of 4%. The decrease in revenue in the first quarter of 2002 compared with the same quarter in 2001 was due primarily to an increase in shipments of our Security products of $3.6 million being more than offset by a $5.3 million decrease of our Digital Media and Video products. The increase in our Security revenue was primarily due to increased shipments of our PC security related products because of stronger demand from our original equipment manufacturing (OEM) customers. The decrease in Digital Media and Video revenue was primarily due to weaker economic conditions in the retail market. Sales to SCM’s top 10 customers accounted for 50% and 47% of total net revenues in the first quarter of 2002 and 2001, respectively.

Gross Profit.Gross profit for the first quarter of 2002 was $14.6 million, or 34% of total net revenue, compared to $4.2 million, or 9%, for the first quarter of 2001. The increase in gross profit in absolute dollars for the first quarter of 2002 as compared to the same period in 2001 was primarily due to a $10.0 million increase in inventory reserves in the 2001 period for our St@rKey PC satellite receiver and our digital media reader products and related components. Our St@rKey product was designed to receive MPEG 1 video over satellite, but changing market requirements prompted us to try and rework the product to receive MPEG 2 video. Following the end of the first quarter of 2001, we determined that St@rKey was not technically feasible to manage MPEG 2 in its current form, and therefore had taken a charge to inventory. In the first quarter of 2001, we increased inventory reserves for our digital media readers, which are custom built for individual customers, after experiencing cancellations of some orders and reducing our expectations for future sales of these products due to generally weaker economic conditions. Excluding the inventory charge, gross profit for the first quarter of 2001 would have been 32% of total revenue. Excluding the inventory reserve increase, the increase in gross margin percentage to 34% in the first quarter of 2002 compared to 32% for the same period in 2001 was primarily due to higher margins related to our Security products. Our gross profit has been and will continue to be affected by a variety of factors, including competition, the volume of sales in any given quarter, product configuration and mix, the availability of new products, product enhancements, software and services, and the cost and availability of components. Accordingly, gross profit percentages are expected to fluctuate from period to period.

Research and Development.Research and development expenses consist primarily of employee compensation and fees for the development of prototype products. To date, the period between achieving technological feasibility and completion of software has been short, and software development costs qualifying for capitalization have been insignificant. Accordingly, SCM has not capitalized any software development costs. For the first quarter of 2002, research and development expenses were $2.9 million, compared with $3.6 million in the first quarter of 2001, a decrease of 20%. As a percentage of total net revenue, research and development expenses were 7% and 8% in the first quarter of 2002 and 2001, respectively. The decrease in absolute amounts was primarily due to decreased personnel costs of $0.7 million reflecting our continued strategic movement of engineering activities from high cost regions such as Silicon Valley to our lower cost locations such as India. Research and development costs as a percentage of net revenue are expected to fluctuate from period to period.

Selling and Marketing.Selling and marketing expenses consist primarily of employee compensation and advertising and other marketing costs. Selling and marketing expenses for the first quarter of 2002 were $6.4 million, or 15% of net revenues, compared with $8.6 million in the first quarter of 2001, or 19% of net revenues, a decrease of 25%. This decrease in absolute amount in 2002 was primarily due to decreases in selling and marketing costs in the U.S. and Europe, primarily for marketing program costs of $1.3 million, personnel related expenses of $0.5 million, and office administrative costs of $0.3 million.

General and Administrative.General and administrative expenses consist primarily of compensation expenses for employees performing SCM’s administrative functions, professional fees such as legal, audit, tax and consulting fees, and changes to allowances for doubtful accounts receivable. In the first quarter of 2002, general and administrative expenses were $4.1 million, a decrease of 33% compared with $6.2 million in the first quarter of 2001, and representing 10% and 14% of total net revenue in the first quarter of 2002 and 2001, respectively. This decrease in the absolute amount in 2002 compared to the same quarter in 2001was primarily

due to a decrease in expense for allowances of doubtful accounts receivable of $1.6 million. We expect that general and administrative costs will fluctuate as a percentage of total net revenue.

Amortization of Goodwill and Intangibles.Amortization of goodwill and intangibles in the first quarter of 2002 was $0.3 million compared with $3.7 million for the same period of 2001. The decrease in goodwill and intangible amortization resulted from the write off of impaired assets in the fourth quarter of 2001 and from the implementation of SFAS No. 142 as of January 1, 2002. Amortization of intangibles for all of fiscal 2002 for acquisitions made before June 30, 2001 will be approximately $1.1 million.

In-Process Research and Development.In-process research and development costs of $0.1 million in the first quarter of 2001 were written off for development efforts that had not yet reached technological feasibility at the time of our residual 2.8% acquisition of Dazzle’s share capital. These development efforts had no alternative future uses as of the acquisition date.

Separation and Restructuring Charges.During the first quarter of 2002, SCM incurred separation and restructuring charges of $0.8 million. These expenses were primarily related to legal and consulting costs of $0.4 million, severance and related costs of $0.3 million and an asset impairment of $0.1 million.

Loss from investments. From time to time, we make strategic investments in both private and public companies. During each quarter, we evaluate our investments for possible asset impairment. We examine a number of factors, including the current economic conditions and markets for each investment, as well as its cash position and anticipated cash needs for the short- and long-term. During the first quarter of 2001, because of the persistent deterioration of general economic conditions, changes in specific market conditions for each investment and difficulties involved in obtaining additional funding, SCM determined that our investments in SmartDisk and Spyrus have been permanently impaired. Accordingly, we wrote down our investment in SmartDisk to its fair market value as of March 31, 2001 and wrote down our investment in Spyrus to its estimated value which approximated 20% of the original cost. The result was a charge to the income statement of $5.7 million in the first quarter of 2001.

Interest and Other, Net. Interest and other, net consists of interest earned on invested cash, offset by interest paid or accrued on outstanding debt and foreign currency gains or losses. In the first quarter of 2002, interest income and other, net, was a net expense of $172,000, compared to a net expense of $33,000 in the first quarter of 2001. Net interest income for the first quarter of 2002 was $0.3 million compared to $0.7 million for the same period in 2001. The decrease was primarily the result of lower average investable cash balances and lower interest rates. Net foreign currency loss for the first quarter of 2002 was $0.4 million compared to a loss of $0.7 million for the first quarter of 2001. The foreign exchange loss in the first quarter of 2002 was primarily due to unfavorable rate changes for the Singapore dollar ($0.2 million) and the British pound ($0.1 million) compared to the United States dollar. The foreign exchange loss in the first quarter of 2001 was primarily due to unfavorable rate changes for the Japanese yen ($0.5 million) and the German mark ($0.3 million) compared to the U.S. dollar.

Benefit for Income Taxes. The benefit for income taxes in the first quarter of 2002 was $0.2 million, or a 219% income tax benefit compared to a 22% benefit in the first quarter of 2001. This effective benefit resulted principally from net losses in the United States and Europe which were partially offset by taxable income generated in other tax jurisdictions. The effective tax benefit was further impacted by expenses not deductible for tax purposes primarily consisting of the amortization of goodwill and intangibles.

Minority interest. The minority interest in earnings reflects the proportional profits or losses that are attributable to the minority shareholder in an SCM subsidiary.

New Divisional Reporting

Throughout 2001, we organized our business around Digital TV and Video, Digital Media and PC Security. Beginning with fiscal 2002 and going forward, we structured our operations around two businesses: Security, which comprises our digital TV and PC security products, and Digital Media and Video, which comprises our digital media and digital video products.

Liquidity and Capital Resources

As of March 31, 2002, our working capital was $102.9 million and approximated our working capital of $101.4 million as of December 31, 2001.

Cash and cash equivalents decreased by $2.5 million during the first quarter of 2002 primarily due to cash used in operating activities of $0.1 million and from cash used in financing activities of $3.0 million being partially offset by a positive foreign exchange rate increase of $0.7 million. Cash used in operations of $0.1 million was primarily due to net income of $0.1 million, the adding back depreciation and amortization of $1.1 million, a decrease in accounts receivable of $4.0 million and an increase of accruals of $0.4 million being more than offset by an increase in inventory of $4.6 million and a decrease of accounts payable of $1.0 million. Cash used in investing activities was primarily from capital expenditures of $0.4 million and purchases of short-term investments of $2.6 million.

The Company has a revolving line of credit with a bank in Germany providing total borrowings of up to 0.8 million Euro (approximately $0.7 million as of March 31, 2002). The German line has no expiration date and bears interest at 7%. Borrowings under this line of credit are unsecured. The Company has an unsecured line of credit in France of 0.3 million Euro (approximately $0.3 million as of March 31, 2002) which bears interest at 4.48% and has no expiration date. In the United States, the Company has an unsecured $3.0 million line of credit which bears interest at 7.0% and expires in May 2002. In addition, the Company has a Singapore $1.2 million (approximately $0.7 million as of March 31, 2002) overdraft facility with a local bank due on demand. The Singapore line is secured by a U.S. $0.4 million fixed deposit and has a base interest rate of 7.0%. There were no amounts outstanding under any of these credit facilities as of March 31, 2002 and December 31, 2001.

We believe that our current capital resources and available borrowings will be sufficient to meet our operating and capital requirements through at least the next twelve months. We may, however, seek additional debt or equity financing prior to that time. We can not assure you that additional capital will be available to SCM on favorable terms or at all. The sale of additional debt or equity securities may cause dilution to existing stockholders.

Factors that May Affect Future Operating Results

You should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations.

If any of the following risks actually occur, our business, financial condition, results of operations or product market share could be materially adversely affected. In such case, the trading price of our common stock could decline and you could lose all or part of your investment.

We have incurred operating losses and may not achieve profitability.

We have a history of losses with an accumulated deficit of $74.3 million as of March 31, 2002. Although we were profitable for the first quarter of 2002 and for the second and third quarters of 2001 (before one-time items and the amortization and impairment of goodwill and intangibles), we may continue to incur losses in the future and may be unable to achieve profitability.

Our quarterly operating results will likely fluctuate.

Our quarterly operating results have varied greatly in the past and will likely vary greatly in the future depending upon a number of factors. Many of these factors are beyond our control. Our revenues, gross margins and operating results may fluctuate significantly from quarter to quarter due to, among other things:


	•	business and economic conditions overall and in our markets, and in particular, the demand in the retail channel;


	•	the timing and amount of orders we receive from our customers that, in the case of our consumer products and products sold to the government, may be tied to seasonal demand or budgetary cycles;

	•	cancellations or delays of customer product orders, or the loss of a significant customer;

	•	our backlog and inventory levels;

	•	our customer and distributor inventory levels and product returns;

	•	new product announcements or introductions by us or our competitors;

	•	our ability to develop, introduce and market new products and product enhancements on a timely basis, if at all;

	•	the sales volume, product configuration and mix of products that we sell;

	•	our success in expanding our sales and marketing organization and programs;

	•	technological changes in the market for our products;

	•	increased competition or reductions in the average selling prices that we are able to charge;

	•	fluctuations in the value of foreign currencies against the U.S. dollar;

	•	the timing and amount of marketing and research and development expenditures;

	•	our investment experience related to our strategic minority equity investments; and

	•	costs related to events such as acquisitions, litigation and write-off of investments.

Due to these and other factors, our revenues may not increase or remain at their current levels. Because a high percentage of our operating expenses are fixed, a small variation in our revenue can cause significant variations in our earnings from quarter to quarter and our operating results may vary significantly in future periods. Therefore, our historical results may not be a reliable indicator of our future performance.


	*A number of factors make it difficult to estimate operating results prior to the end of a quarter.*

We do not typically maintain a significant level of backlog. As a result, revenues in any quarter depend on contracts entered into or orders booked and shipped in that quarter. In recent periods, customers, including distributors of our consumer products, have tended to make a significant portion of their purchases towards the end of the quarter, in part because they are able, or believe that they are able, to negotiate lower prices and more favorable terms. This trend makes predicting revenues difficult. The timing of closing larger orders increases the risk of quarter-to-quarter fluctuation. If orders forecasted for a specific group of customers for a particular quarter are not realized or revenues are not otherwise recognized in that quarter, our operating results for that quarter could be materially adversely affected.


	*Weakness in the economy could decrease demand for our products or for our customers’ products, causing customers to decrease or cancel orders to us or to delay payment.*

Over the past several quarters, economic conditions in the United States have resulted in decreased demand from end users for many companies’ products, including ours. Throughout 2001 and during 2002 through the date hereof, we have experienced decreased actual and anticipated demand for our retail digital video editing products and for our digital media reader/writers sold through the retail and OEM channels. Reductions in consumer spending impacts our OEM business as well as our retail business because our OEM customers may reduce or cancel orders for our products if their own visibility of future orders is compromised by decreased demand or if increased pricing pressures force them to reduce costs by ceasing to bundle our products along with their own. Decreased or lower than expected sales will most likely adversely affect our stock price. Also, reduced or canceled orders for our products could lead to decreased sales in a particular period and, because many of our products are custom made for particular customers, could also cause us to write off inventory. In some cases, customers could delay payment or be unable to pay for orders made to us, causing us to increase our allowance for doubtful accounts or to write off certain receivables. In addition, if we

anticipate that demand for our products will not increase, we may decide to reduce our operating expense base in order to maintain or reach profitability. Decreased sales, expense base decreases or any write-offs, or any combination of these, could have a materially adverse affect on our operating results.


	*There are risks associated with our decision to separate our Digital Media and Video business and our Security business.*

On February 28, 2002, we announced our intention to create two distinct businesses within SCM, a Security business and a Digital Media and Video business. In addition, we announced our intention to separate our Digital Media and Video business as an independent entity and make our Security business the core focus of our strategy going forward. During the first quarter of 2002, we initiated activities to create a separate legal entity around our Digital Media and Video business in preparation for its separation, which we expect will not be completed for several months. If we were unable to properly implement the separation, our revenues, results of operations and our stock price could be adversely affected. Risks which could impact our ability to properly implement the separation include:


	•	the separation process and results thereof will occupy a significant portion of senior management time and effort and may distract management and employees from the operation of these businesses;

	•	the separation could be delayed or cancelled;

	•	our separation strategy could be perceived negatively by our customers or cause them to choose our competitors’ products instead of ours;

	•	implementation of the separation strategy could make it more difficult for us to retain employees and may otherwise adversely affect employee morale; and

	•	adverse market perception of the separation may cause our stock price to decline.

Also, there is no assurance that we will effectively implement the separation in a timely manner or at all. This implementation requires management to make and effect several administrative and employment-related decisions efficiently. If we do not implement these decisions efficiently, our operating results could be adversely affected. Furthermore, there is no assurance that, if we do implement the separation efficiently and in a timely manner, we will realize the benefits we contemplate from the separation. If we do not realize these benefits, our operations could be adversely affected and our stock price could decline.


	*Our listing on the Neuer Markt of the Frankfurt Stock Exchange exposes our stock price to additional risks of fluctuation.*

Our common stock experiences a significant volume of trading on the Neuer Markt of the Frankfurt Stock Exchange. Because of this, factors that would not otherwise affect a stock traded solely on Nasdaq may cause our stock price to fluctuate. Investors outside the United States may react differently and more negatively than investors in the United States to events such as acquisitions, one-time charges and lower than expected revenue or earnings announcements. Any negative reaction by investors in Europe to such events could cause our stock price to decrease. In addition, the European economy and market conditions in general, or downturns on the Neuer Markt specifically, regardless of the Nasdaq market conditions, could negatively impact our stock price.

Our stock price has been and is likely to remain volatile.

The stock market has recently experienced significant price and volume fluctuations that have particularly affected the market prices of the stocks of technology companies. During the 12-month period from April 21, 2001 to April 20, 2002, the reported sale prices for our common stock on the Nasdaq market ranged

between $4.70 and $16.65 per share. Volatility in our stock price may result from a number of factors, including:


	•	variations in our or our competitors’ financial and/or operational results;

	•	the fluctuation in market value of comparable companies in any of our markets;

	•	comments and forecasts by securities analysts;

	•	expected or announced relationships with other companies;

	•	trading patterns of our stock on the Nasdaq Stock Market or the Neuer Markt of the Frankfurt Stock Exchange;

	•	any loss of key management;

	•	announcements of technological innovations or new products by us or our competition;

	•	developments related to our decision to organize our company around a Security business and a Digital Media and Video business and to separate our Digital Media and Video business and focus on our Security business as a core strategy;

	•	litigation developments; and

	•	general market downturns.

In the past, companies that have experienced volatility in the market price of their stock have been the object of securities class action litigation. If we were the object of securities class action litigation, it could result in substantial costs and a diversion of our management’s attention and resources.

Sales of our products depend on the development of several emerging markets.

We sell our products primarily to emerging markets that have not yet reached a stage of mass adoption or deployment. If demand for products in these markets does not develop and grow sufficiently, revenues and gross profit margins in either or both of our Security or our Digital Media and Video businesses could level off or decline. We cannot predict the future growth rate, if any, or size or composition of the market of our products in any of these markets. The demand and market acceptance for our products, as is common for new technologies, will be subject to high levels of uncertainty and risk and may be influenced by several factors, including general economic conditions.

In our Security business, these factors also include the following:


	•	the slow pace and uncertainty of adoption in Europe of open systems platforms that require conditional access modules, such as ours, that use the Digital Video Broadcasting-Common Interface standard;

	•	the strength of entrenched security and set-top receiver suppliers in the United States who may resist the use of removable conditional access modules, such as ours, and prevent or delay opening the U.S. digital television market to greater competition; and

	•	the ability of financial institutions, corporate enterprises and the U.S. government to create and deploy smart card-based applications that will drive demand for smart card readers such as ours.

In our Digital Media and Video business, demand for our products will also be influenced by the following:


	•	the ability of flash memory card manufacturers to develop higher capacity memory cards that will drive demand for digital media readers, such as ours, that enable rapid transfer of large amounts of data;

	•	the availability of low cost hardware and software OEM solutions to allow expansion in the PC OEM market; and

	•	increased consumer acceptance of DVDs, CDs and DVD players and readers.


	If we are unable to develop and maintain the strategic relationships necessary to develop, sell and market products that are commercially viable and widely accepted, the growth and success of our business may be limited.

If we are unable to anticipate market trends and the price, performance and functionality requirements for our products, we may not be able to develop and sell products that are commercially viable and widely accepted. We must collaborate closely with our customers, suppliers and other strategic partners to ensure that critical development, marketing and distribution projects proceed in a coordinated manner. Also, this collaboration is important because these relationships increase our exposure to information necessary to anticipate trends and plan product development. If any of our current relationships terminate or otherwise deteriorate, or if we are unable to enter into future alliances that provide us with comparable insight into market trends, our product development and marketing efforts may be adversely affected.


	*Our future success will depend on our ability to keep pace with technological change and meet the needs of our target markets and customers.*

The markets for our Security and Digital Media and Video products are characterized by rapidly changing technology and the need to differentiate our products through technological enhancements. Our customers’ needs change and new products are introduced frequently. Product life cycles are short and industry standards are still evolving. These rapid changes in technology, or the adoption of new industry standards, could render our existing products obsolete and unmarketable. If one of our products is deemed to be obsolete or unmarketable, then we might have to reduce revenue expectations or write off inventories for that product. Our future success will depend upon our ability to enhance our current products and to develop and introduce new products on a timely basis that address the increasingly sophisticated needs of our customers and that keep pace with technological developments, new competitive product offerings and emerging industry standards. In addition, in cases where we are selected to supply products based on features or capabilities that are still under development, we must be able to complete our product design and delivery process in a timely basis, or risk losing current and any future business from our customers.

For example, our SmartReady, SmartSecure, SmartTrust and SmartRetail product families are designed to provide smart card-based security for PCs. Smart cards are beginning to be widely deployed by financial institutions, the U.S. government, corporations and other large organizations, in some cases in advance of anticipated security-oriented applications. However, standards for smart card readers are still emerging. We may not be able to comply with emerging standards in a timely manner or at all. If we cannot meet the standards requirements of the market or our prospective customers, we would likely lose orders to competitors.

Because we operate in markets for which industry-wide standards have not yet been fully set, it is possible that any standards eventually adopted could prove disadvantageous to or incompatible with our business model and product lines. If any of the standards supported by us do not achieve or sustain market acceptance, our business and operating results would be materially and adversely affected.


	*Our markets are highly competitive, and our customers may purchase products from our competitors.*

The markets for our products are intensely competitive and characterized by rapidly changing technology. We believe that the principal competitive factors affecting the markets for our products include:


	•	the extent to which products support existing industry standards and provide interoperability;

	•	technical features;

	•	ease of use;

	•	quality and reliability;

	•	level of security;

	•	brand name, particularly in retail channels;

	•	strength of distribution channels; and

	•	price.

We believe that competition in our markets is likely to intensify as a result of increasing demand for the type of products we offer. We currently experience competition from a number of companies. In our Security business, our competitors include:


	•	Advanced Card Systems, Gemplus, O2Micro and OmniKey in smart card readers, ASICs and universal smart card reader interfaces.

		In our Digital Media and Video business, our competitors include:

	•	Carry Computer Engineering, DataFab, Lexar, SanDisk, Simple Technology and SmartDisk for digital media readers; and

	•	ADS, Canopus, Pinnacle Systems, Roxio and ULead for digital video capture and editing products.

We also experience indirect competition from some of our customers who sell alternative products or are expected to introduce competitive products in the future. We may in the future face competition from these competitors and new competitors, such as Motorola, that develop digital security products. In addition, the market for our products may ultimately include technological solutions other than ours and our competitors.

Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies or standards and to changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products and may be able to deliver competitive products at a lower end user price. Current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products to address the needs of our prospective customers. Therefore, new competitors, or alliances among competitors, may emerge and rapidly acquire significant market share. Increased competition is likely to result in price reductions, reduced operating margins and loss of market share.


	*Seasonal trends in sales of our products may affect our quarterly operating results.*

Our business and operating results normally reflect seasonal trends. We have typically experienced lower revenue and operating income in the first quarter and second quarter and higher revenue in the third quarter and fourth quarter of each calendar year. We believe that the seasonal trends in our business and operating results are primarily due to the retail selling cycles of our consumer-oriented products, including our Digital Media and Video products. Because the market for consumer products is stronger in the second half of the year, we generally expect that our sales to retail distributors and to consumer-oriented OEMs will increase during that period. However, because of the unpredictability of the U.S. economy, there is no assurance that this increase will occur in the second half of 2002. In addition, our sales are impacted by the buying patterns of the U.S. government, which is an important customer for our PC Security products. These patterns tend to be variable in terms of the timing and size of orders, which contributes to the variability of our results on a quarterly basis.


	*A significant portion of our sales comes from a small number of customers and the loss of one of more of these customers could negatively impact our operating results.*

Our products are generally targeted at OEM customers in the consumer electronics, computer, digital appliance, digital media and conditional access system industries, and to retail distributors. Sales to a relatively small number of customers historically have accounted for a significant percentage of our total sales. For example, sales to our top 10 customers accounted for approximately 42% of our total net revenue in fiscal 2001, with one customer, Aston-France S.A.R.L., accounting for 11% of our net revenue. For the first quarter of 2002, sales to our top 10 customers accounted for approximately 50% of our total net revenue, with Aston-France S.A.R.L. accounting for 16% of our net revenue. We expect that sales of our products to a limited number of customers will continue to account for a high percentage of our total sales for the foreseeable future. The loss or reduction of orders from a significant OEM or retail customer, including losses or reductions due to manufacturing, reliability or other difficulties associated with our products, changes in customer buying patterns, or market, economic or competitive conditions in the digital information security

business or digital media and video business, could result in decreased revenues and/or inventory or receivables write-offs and otherwise harm our business and operating results.


	*We face risks related to our increased dependence on a retail distribution model for distribution of our Digital Media and Video products.*

Historically, we sold substantially all our products directly to OEM customers. Following our acquisitions of Dazzle Multimedia and Microtech, we now sell a significant percentage of our products through our retail channel. Direct retail distribution creates additional risks for us including:


	•	increased exposure to demand cycles caused as a result of seasonal or economic trends;

	•	generally lower margins for products due to, among other factors, greater price competition and increased promotional and distribution costs;

	•	the need to develop, and the related marketing expense of developing brand recognition for our Dazzle branded products;

	•	the need to protect the reputation of our brand for quality and value; and

	•	the need to successfully and cost-effectively maintain current retail channels and develop new retail distribution channels for these products.

We sell a substantial portion of our Digital Media and Video products through retailers, including Best Buy, CompUSA, Dixons/ PC World, Fry’s Electronics, Office Depot, Staples, Sears, B&H Photo, The Good Guys, MicroCenter and CameraWorld.com. Our retail distributors may have limited capital to invest in inventory, and their decisions to purchase our products are partly a function of pricing, terms and special promotions offered by us and our competitors over which we have no control and which we can not predict. We could lose market share if the retailers that carry our products do not grow as quickly as retailers that carry our competitors’ products. Also, the amount of our products that retailers purchase is subject to factors we do not control. For instance, retailers’ decisions to purchase our products depend on pricing, terms and special promotions offered by our competitors. If retailers choose not to purchase our products or choose to purchase less than what we expect, our sales will decrease or not grow at the rate we expect.

We also sell our digital video products through distributors, including Ingram Micro, Northamber and Tech Data. Our distributor agreements are generally nonexclusive and may be terminated by either party without cause. If these agreements are terminated, we may not be able to find other distributors willing to purchase our digital video products. Certain distributors have experienced financial difficulties in the past. Distributors that account for significant sales of our consumer products may experience financial difficulties in the future, which could lead to reduced sales or write-offs.

Because a large percentage of our Digital Media and Video sales are to a small number of customers that are primarily retailers or distributors, this can exert pressure on our revenues generated from these customers. As a result of this pricing pressure, we have reduced and may need to continue to reduce the prices of some of our Digital Media and Video products. Any reduction in prices will negatively impact our gross margins unless we are able to reduce our costs. Also, some customers are requesting that we sell our products to them on a consignment basis. If we agree to these arrangements, our inventory levels will increase, and this will increase our costs and the risk of inventory write-offs.


	*We have global operations, which require significant managerial and administrative resources.*

Operating in diverse geographic locations imposes significant burdens on our managerial resources. In particular, our management must:


	•	divert a significant amount of time and energy to manage employees and contractors from diverse cultural backgrounds and who speak different languages;

	•	manage different product lines for different markets;


	•	manage our supply and distribution channels across different countries and business practices; and

	•	coordinate these efforts to produce an integrated business effort, focus and vision.

In addition, we are subject to the difficulties associated with operating in a number of time zones, which may subject us to additional unforeseen difficulties or logistical barriers. Operating in widespread geographic locations requires us to implement and operate complex information and operational systems. In the future we may have to exert managerial resources and implement new systems that may be costly. Any failure or delay in implementing needed systems, procedures and controls on a timely basis or in expanding current systems in an efficient manner could have a material adverse effect on our business and operating results.


	*Our key personnel are critical to our business, and such key personnel may not remain with us in the future.*

We depend on the continued employment of our senior executive officers and other key management and technical personnel. If any of our key personnel leave and are not adequately replaced, our business would be adversely affected. We provide compensation incentives such as bonuses, benefits and option grants, which are typically subject to vesting over four years, to attract and retain qualified employees. In addition, certain of our executive officers are subject to one-year non-compete agreements. Non-compete agreements are, however, generally difficult to enforce. Employee retention may become more difficult because of the uncertainty associated with the separation of our Security and Digital Media and Video businesses. Even though we provide competitive compensation arrangements to our executive officers and other employees, we cannot be certain that we will be able to retain them, including those individuals that are subject to non-compete agreements.

We believe that our future success will depend in large part on our continuing ability to attract and retain highly qualified technical and management personnel. Competition for such personnel is intense, and we may not be able to retain our key technical and management employees or to attract, assimilate or retain other highly qualified technical and management personnel in the future.


	*Our OEM customers may develop technology similar to ours, resulting in a reduction in related customer purchases, canceled orders and direct competition from these customers.*

We sell our products to many OEMs who incorporate our products into their offerings or who resell our products in order to provide a more complete solution to their customers. If our OEM customers develop their own products to replace ours, this would result in a loss of sales to those customers as well as increased competition for our products in the marketplace. In addition, these OEM customers could cancel outstanding orders for our products, which could cause us to write down inventory already designated for those customers.


	*The rapid growth of our businesses may create significant burdens on our systems.*

Our business has grown substantially, with net revenue increasing from $23.6 million in 1995 to $184.9 million in 2001. Net revenue was $43.4 million for the first quarter of 2002. We have expanded our Security business from solutions for the PC platform to include solutions for the digital television platform and have entered into the digital media and video markets. Managing businesses in each of these markets requires skilled management and substantial resources. To address our need for additional resources and because of various acquisitions, we have increased in size from 67 employees at December 31, 1995 to 521 as of December 31, 2001. As of March 31, 2002, we had 515 employees.

Our business model contemplates continued revenue growth. If we do not manage this growth effectively, our stock price and financial condition could be materially and adversely affected. Our growth and our growth plans have placed and are likely to continue to place a significant burden on our operating and financial systems and increase responsibility for senior management and other personnel. Our existing management or any new members of management may not be able to improve our existing systems and controls or implement new systems and controls in response to our anticipated growth. In addition, our intention to reduce or re-deploy personnel to reduce expenses from time to time may limit our capacity to grow.


	*Any delays in our normally lengthy sales cycle could result in significant fluctuations in our quarterly operating results.*

Our initial sales cycle for a new OEM customer or retail distributor usually takes six to nine months. During this sales cycle, we may expend substantial financial resources and our management’s time and effort with no assurance that a sale will ultimately result. The length of a new customer’s sales cycle depends on a number of factors that we may not be able to control. These factors include the customer’s product and technical requirements and the level of competition we face for that customer’s business. Any delays in the sales cycle for new customers would limit our receipt of new revenue and might cause us to expend more resources to obtain new customer wins.


	*We face risks associated with our past and future acquisitions.*

A component of our business strategy is to seek to buy businesses, products and technologies that complement or augment our existing businesses, products and technologies. In 2000, we completed four acquisitions:


	•	Microtech in June 2000;

	•	2-Tel B.V. in September 2000;

	•	Dazzle Multimedia in December 2000, by acquiring substantially all of the outstanding minority interest; and

	•	the Personal Video Division of FAST Multimedia in July 2000, an acquisition completed through Dazzle Multimedia.

In the first quarter of 2002, SCM announced its intent to acquire Towitoko AG, a leading supplier of smart card-based security solutions for home banking and private PC access in the German-speaking market. The acquisition is expected to be completed in the second quarter of 2002.

The integration of the business and operations of any past or future acquisition is a complex, time consuming and expensive process. In order to successfully integrate any acquisition, we must, among other things, successfully:


	•	attract and retain key management and other personnel;

	•	integrate, both from an engineering and a sales and marketing perspective, the acquired products into our product offerings;

	•	coordinate research and development efforts;

	•	integrate sales forces;

	•	consolidate duplicate facilities; and

	•	cost effectively manage our combined business.

Past and future acquisitions may disrupt ongoing operations, divert management from day-to-day business and adversely impact our results of operations. In addition, these types of transactions often result in charges to earnings for such things as transaction expenses, amortization of goodwill, or expensing of in-process research and development. Our available cash and our securities may be used to buy or invest in companies or products, which could result in significant acquisition-related charges to earnings and dilution to our stockholders. Moreover, if we buy a company, we may have to incur or assume that company’s liabilities, including liabilities that are unknown at the time of acquisition. We may be unable to complete any given acquisitions, which may limit the growth of our future revenues.

During the fourth quarter of 2001, the Company evaluated its intangible assets for possible impairment by examining a number of factors including the current economic conditions and markets of past acquisitions and their products, as well as the Company’s best estimates for future revenues, cost of goods sold and operating costs related to those products. An independent valuation firm was used to assess the current value of these

intangible assets given the information available. Based on the independent valuation firm’s finding, the Company determined that the intangible assets from a number of past acquisitions were impaired. The Company recorded a $36.1 million impairment charge in 2001 in order to adjust intangible assets to their estimated fair value as of December 31, 2001.


	*Our business is subject to risks related to our international sales.*

We were originally a German corporation, and we continue to conduct a substantial portion of our business in Europe. Approximately 58%, 48% and 52% of our revenues for the years ended December 31, 2001, 2000 and 1999, respectively, were derived from customers located outside the United States. Approximately 56% of our revenues for the quarter ended March 31, 2002, was derived from customers located outside the United States. Because a significant number of our principal customers are located in other countries, we anticipate that international sales will continue to account for a substantial portion of our revenues. As a result, a significant portion of our sales and operations may continue to be subject to certain risks, including:


	•	foreign currency exchange rate change, especially since we do not currently engage in hedging activities with respect to our foreign currency exposure;

	•	tariffs and other trade barriers, including import and export restrictions;

	•	potential adverse tax consequences;

	•	political or economic instability;

	•	compliance with foreign laws;

	•	difficulties in protecting intellectual property rights in foreign countries; and

	•	transportation delays and interruptions.


	*We could lose money and our stock price could decrease as a result of write downs of our strategic investments.*

We have made strategic minority investments in private and public companies and in the future we may make additional strategic minority investments. Our strategic investments involve a number of risks and we have written down a number of these investments in 2001, including SmartDisk, Spyrus, and Satup. We may not realize the expected benefits of these transactions and we may lose all or a portion of our investment, particularly in the case of our private investments. If we were to lose these investments or if the investments were determined to be impaired, we would be forced to write off all or a portion of these investments, which would have a negative impact on our earnings in any given quarter.


	Our products may have defects, which could damage our reputation, decrease market acceptance of our products, cause us to lose customers and revenue and result in liability to us, including costly litigation.

Highly complex products such as our Digital Media and Video hardware and software products may contain defects for many reasons, including defective design or defective material. Often, these defects are not detected until after the products have been shipped. If any of our products contain defects or have reliability, quality or compatibility problems, our reputation might be damaged significantly, we could lose or experience a delay in market acceptance of the affected product or products, and we might be unable to retain existing customers or attract new customers. In addition, these defects could interrupt or delay sales. We may have to invest significant capital, technical, managerial and other resources to correct potential problems and potentially divert these resources from other development efforts. If we fail to provide solutions to potential problems, we could also incur product recall, repair or replacement costs. These potential problems might also result in claims against us by our customers or others.

In addition, customers of our Security business rely on our token-based security products to prevent unauthorized access to their digital information. A malfunction of or design defect in our products could result

in legal or warranty claims. Although we place warranty disclaimers and liability limitation clauses in our sales agreements and maintain product liability insurance, these measures may be ineffective in limiting our liability. Liability for damages resulting from security breaches could be substantial and the adverse publicity associated with this liability could adversely affect our reputation. These costs could have a material adverse effect on our business and operating results. In addition, a well-publicized security breach involving token-based and other security systems could adversely affect the market’s perception of products like ours in general, or our products in particular, regardless of whether the breach is actual or attributable to our products. In that event, the demand for our products could decline, which would cause our business and operating results to suffer.


	*Our business could suffer if we or our contract manufacturers cannot meet production requirements.*

Most of our products are manufactured outside the United States because we believe that global sourcing enables us to achieve greater economies of scale, improve gross margins and maintain uniform quality standards for our products. Any significant delay in our ability to obtain adequate supplies of our products from our current or alternative sources would materially and adversely affect our business and operating results. In an effort to reduce our manufacturing costs, we have shifted volume production of many of our product components to our wholly owned subsidiary in Singapore, SCM Microsystems (Asia) Pte. Ltd. In addition, we use contract manufacturers in Europe and Asia. Foreign manufacturing poses a number of risks, including:


	•	transportation delays and interruptions;

	•	difficulties in staffing;

	•	currency fluctuations;

	•	potentially adverse tax consequences;

	•	unexpected changes in regulatory requirements;

	•	tariffs and other trade barriers; and

	•	political and economic instability.

If we or any of our contract manufacturers cannot meet our production requirements, we may have to rely on other contract manufacturing sources or identify and qualify new contract manufacturers. Despite efforts to do so, we may be unable to identify or qualify new contract manufacturers in a timely manner and these new manufacturers may not allocate sufficient capacity to us in order to meet our requirements.

We design and manufacture new products and technologies to address emerging markets that are early in their life cycles. In many cases, our products are the first of their kind to address the evolving business requirements of our customers. While we perform initial beta testing on all our products, in certain cases we are unable to test the efficacy of the design or functionality of our products for mass production. If we are successful in securing large contracts for our products, we cannot be certain that we will be able to produce them in sufficient quantities and that they will meet customer specifications.


	*We have a limited number of suppliers of key components.*

We rely upon a limited number of suppliers of several key components of our products. For example, we currently utilize the foundry services of TEMIC, Philips and Atmel to produce our ASICs for our digital TV modules, we utilize the foundry services of Atmel and Samsung to produce our ASICs for our smart cards readers, and we purchase digital video compression chips from Zoran and LSI Logic and digital video editing software from Main Concept and DVD Cre8. Our reliance on only one supplier could impose several risks, including an inadequate supply of components, price increases, late deliveries and poor component quality. Disruption or termination of the supply of these components could delay shipments of our products. These delays could have a material adverse effect on our business and operating results and could also damage relationships with current and prospective customers.


	*We may be exposed to risks of intellectual property infringement by third parties.*

Our success depends significantly upon our proprietary technology. We currently rely on a combination of patent, copyright and trademark laws, trade secrets, confidentiality agreements and contractual provisions to protect our proprietary rights. Our software, documentation and other written materials are protected under trade secret and copyright laws, which afford only limited protection. We generally enter into confidentiality and non-disclosure agreements with our employees and with key vendors and suppliers.

Our SmartOS and SmartReady trademarks are registered in the United States, and we continuously evaluate the registration of additional trademarks as appropriate. We currently have patents issued in both the United States and Europe and have other patent applications pending worldwide. In addition, we have licenses for various other U.S. and European patents associated with our products. Although we often seek to protect our proprietary technology through patents, it is possible that no new patents will be issued, that our proprietary products or technologies are not patentable or that any issued patent will fail to provide us with any competitive advantages.

There has been a great deal of litigation in the technology industry regarding intellectual property rights. Litigation may be necessary to protect our proprietary technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or to use our proprietary information and software. In addition, the laws of some foreign countries do not protect proprietary and intellectual property rights to as great an extent as do the laws of the United States. Because many of our products are sold and a portion of our business is conducted overseas, primarily in Europe, our exposure to intellectual property risks may be higher. Our means of protecting our proprietary and intellectual property rights may not be adequate.


	We may face claims of infringement of the intellectual rights of third parties, which could subject us to costly litigation, supplier and customer indemnification claims and the possible restriction on the use of our intellectual property.

We have from time to time received claims that we are infringing upon third parties’ intellectual property rights. Our suppliers and customers may also receive similar claims. We have historically agreed to indemnify suppliers and customers for alleged patent infringement. The scope of this indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorney’s fees. We may periodically engage in litigation as a result of these indemnification obligations. Our insurance policies exclude coverage for third party claims for patent infringement.

As the number of products and competitors in our target markets grows, the likelihood of infringement claims also increases. Any claims or litigation may be time-consuming and costly, cause product shipment delays, or require us to redesign our products or enter into royalty or licensing agreements. If we are unable to modify our products or obtain a license on commercially reasonable terms, or at all, a competitor of ours or a claimant against us or our customers may stop us or our customers from selling the allegedly infringing products.

If we decide to incorporate third party technology into our products or if we are found to infringe on others�� intellectual property, we could be required to license intellectual property from a third party. We may also need to license some of our intellectual property to others in order to enable us to obtain cross-licenses to third party patents. We cannot be certain that licenses will be offered when we need them or that the terms offered will be acceptable. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments. In addition, if we are unable to obtain a license that is necessary to the manufacture of our products, we could be required to suspend the manufacture of products or stop our suppliers from using processes that may infringe the rights of third parties. We may be unsuccessful in redesigning our products or in obtaining the necessary licenses under reasonable terms or at all.


	*We may have to take back unsold Digital Media and Video inventory from our customers.*

Although our contractual obligations to accept returned products from our retail, distributor and OEM customers are limited, if consumer demand is less than anticipated these customers may ask that we accept returned products. We may determine that it is in our best interest to accept returns in order to maintain good relations. While we have experienced some product returns to date, returns may increase more than present levels in the future.


	*Our failure to promote our brand successfully and achieve strong brand recognition in our target markets could limit or reduce demand for our Digital Media and Video products.*

We believe that brand recognition will be important to our success, particularly the recognizability of our Dazzle brand. We plan to market this brand to increase awareness. If we fail to promote our brand successfully or if our marketing expenses are too large, our business may not grow as we anticipate. Also, if our products perform poorly or have other problems, the value of our brand will decrease.


	*We may experience significant amortization charges and may have future non-recurring charges as a result of past acquisitions.*

In connection with our previous acquisitions accounted for under the purchase method of accounting, in future periods we may experience significant charges related to the amortization of certain intangible assets. In addition, if we later determine that our intangible assets or goodwill are impaired, we will be required to take a related non-recurring charge to earnings.


	*Factors beyond our control could disrupt our operations and increase our expenses.*

We face a number of potential business interruption risks that are beyond our control. In 2001, the State of California experienced:


	•	intermittent power shortages;

	•	sharp increases in the cost of energy; and

	•	interruptions of service to some business customers.

If power shortages continue to be a problem our business may be materially adversely effected. Additionally, we may experience natural disasters that could interrupt our business. Our corporate headquarters are located near a major earthquake fault. The potential impact of a major earthquake on our facilities, infrastructure and overall operations is not known. Safety precautions have been implemented; however there is no guarantee that an earthquake would not seriously disturb our entire business process.


Item 3.	*Quantitative and Qualitative Disclosure about Market Risk Foreign Currencies*

Foreign Currencies

SCM Microsystems transacts business in various foreign currencies, primarily in certain European countries, the United Kingdom, Singapore and Japan. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to yen denominated sales in Japan and local currency denominated operating expenses in the UK, Europe and Singapore, where we sell in both local currencies and U.S. dollars. We currently do not use financial instruments to hedge local currency activity at any of our foreign locations. Instead, we believe that a natural hedge exists, in that local currency revenues substantially offset the local currency denominated operating expenses. We assess the need to utilize financial instruments to hedge foreign currency exposure on an ongoing basis.

SCM’s foreign currency transactions gains and losses are primarily the result of the revaluation of intercompany receivables/payables (denominated in U.S. dollars) and trade receivables (denominated in a currency other than the functional currency) to the functional currency of the subsidiary.

Fixed Income Investments

SCM’s exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments for speculative or trading purposes. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy. The policy also limits the amount of credit exposure to any one issue, issuer and type of instrument. We do not expect any material loss with respect to our investment portfolio.

We do not use derivative financial instruments in our investment portfolio to manage interest rate risk. We do, however, limit our exposure to interest rate and credit risk by establishing and strictly monitoring clear policies and guidelines for our fixed income portfolios. At the present time, the maximum duration of all portfolios is limited to two years. The guidelines also establish credit quality standards, limits on exposure to one issue, issuer, as well as the type of instrument. Due to the limited duration and credit risk criteria established in our investment guidelines, the exposure to market and credit risk is not expected to be material.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings

Not applicable.

Item 2. Changes in Securities and Use of Proceeds

Not applicable.

Item 3. Defaults upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the first quarter of 2002.

Item 5. Other Information

Not applicable.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits.

None

(b) Reports on Form 8-K

None.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


	SCM MICROSYSTEMS, INC.

	/s/ ANDREW WARNER

	Andrew Warner
	Vice President, Finance and Chief Financial Officer
	(Principal Financial and Accounting Officer)

Date: May 3, 2002

Positive
Negative
Uncertain
Constraining
Legalese
Litigious
Readability	8th grade V good

Identiv (INVE) 10-Q2002 Q1 Quarterly report

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